Are 'safe' investments smart?

Principal-protection funds gain in popularity, but some warnings apply

By

VanessaRichardson

SAN FRANCISCO (CBS.MW) -- Sensing investors' skittish mood these days, Wall Street has been cooking up a new batch of "principal-protection" investments designed to be more predictable, less volatile, and to deliver modest returns.

Some are even offering the possibility of equity-like gains with little or no risk to principal.

"There has been a boom in filings for creation of principal-protection funds and variable annuities over the past six months," said Lisa Plotnick, an analyst for Financial Research Corp. in Boston.

Citigroup's
C, -1.64%
Smith Barney, IDEX
IEX, -2.32%
and Merrill Lynch
MER, -2.00%
are among the financial giants who recently filed. And investors seem interested. The Smith Barney Capital Preservation Fund
SPNAX
launched last spring, took in $900 million in five weeks, spurring the company to open another fund.

Principal-protection funds use a combination of bonds, equities and insurance to guarantee an investor's principal over a fixed time period, usually five or seven years. There's a fixed subscription period, about three months, as the fund builds up assets.

After that, the fund is closed and assets are invested in equities and bonds, typically zero-coupon Treasuries. Management essentially divvies up the assets so a fund's guarantees are covered by fixed-return investments while gains are made from the variable portion of the fund. As the market rises, more assets go to equities and bonds, and vice-versa.

This investment type started as Guaranteed Investment Contracts some two decades ago. Their offspring, stable-value and principal-protection funds, were increasingly used in the 401(k) market but weren't available to individual investors until the mid-1990s.

It took a bear market for them to gain interest, Plotnick said. "Funds with an implied guarantee flew under the radar during the bull market, but current volatility has made funds with the words 'stable,' 'protection' and 'preservation' in their names very appealing to investors."

Now these words are also appearing in variable annuity offerings. Insurance giant ING Group
ING, -2.09%
has launched four principal-protection funds since 2000, which have attracted more than $500 million each.

ING Group recently created its second Pilgrim Protection Fund, a closed-end mutual fund that trades on the exchange like a stock but guarantees the original principal at the end of five years, and is offering it as a sub-account to its VA clientele.

American Skandia Life Assurance Corp. is offering the guaranteed return option, which vouches for the principal after seven years, on seven of its annuities. Since it was introduced last summer, the option has been added to 13,000 VA holders' accounts.

It was developed by extensive work with focus groups, said Jac Herschler, vice-president of variable annuity marketing at American Skandia. "People love the notion that they have a guarantee and they'll believe in the upside -- if the fear of loss can be lessened."

How safe is safe?

Yet many investment pros are skeptical about the so-called safety of these funds. Brian Portnoy, a fund analyst for Morningstar, says they're expensive, confusing and inappropriate for investors with long-term goals.

"Since they're a hybrid of stocks and bonds, they're harder for the investor to clearly track. Plus, the prospectuses are hard to read and the investing strategies are opaque. These are clearly under the product marketing umbrella," Portnoy said.

A major downside is that the insurance contract for the money-back guarantee makes these funds expensive. Expenses for A shares of the Smith Barney Capital Preservation Fund are 1.95 percent, and other classes are even higher at 2.7 percent. Compare that to an expense of 1.28 percent for the average blended fund.

"The expenses are so high that the potential gain is minimal," Portnoy said.

And most funds are already so conservative that the insurance isn't necessary, said Ann Terranova, a financial planner with Union Financial Partners in San Francisco. "These funds are usually tilted heavily towards zero-coupons anyway."

ING's Classic Principal Protection
APPAX
is 90 percent bonds, while the Smith Barney Capital Preservation Fund has held only cash and bonds since its inception.

Who calls the shots at these funds is also unclear. If the insurance company providing the guarantee thinks management is taking on too much risk, it can take over asset-allocation duties. "In managing risk, investment performance often drops out of the equation," Portnoy said.

Ask questions first

If principal protection still sounds attractive, Portnoy advises asking these questions about any specific fund:

Does it match your goals? Can you retire with limited or no capital growth? If you need substantial capital appreciation, look elsewhere.

Does it match your time horizon? Read the fine print to see how long your investment is locked up. Stable-value funds, which are essentially insured bond portfolios that can out-yield money-market funds, are good cash-management tools, but principal-protection funds can tie up capital for five to 10 years.

What's the total cost? In addition to high sales charges, principal-protection funds often have steep expense ratios and redemption fees.

See if there are better alternatives to add to the bond mix of your portfolio. Compare them to high-quality bond funds in terms of turnover rates, expenses and potential return, Terranova said.

"If insurance companies are offering a return of 5 percent, they're definitely thinking they'll make more than that and keep the profit," she said. "If high-quality bonds are good for them, they're good enough for individuals to buy -- plus they get to keep the profits."

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.